BESTUUR STELT ZICH VOOR... Turmoil on credit markets and a closer look on the credit crunch STELLING: VROUWEN KUNNEN BETER BELEGGEN DAN MANNEN

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1 NOVEMBER e JAARGANG NUMMER 1 BESTUUR STELT ZICH VOOR... Turmoil on credit markets and a closer look on the credit crunch STELLING: VROUWEN KUNNEN BETER BELEGGEN DAN MANNEN

2 INHOUDSOPGAVE COLOFON Colofon Uitgever Financiële Studievereniging Amsterdam Hoofdredacteur Alfred Prevoo Druk Grafiplan Nederland BV Vormgeving & DTP Dylan Polak studiopolak.nl Advertenties Fiducie verschijnt vier keer per jaar. Voor advertenties kan contact worden opgenomen met de Financiële Studievereniging Amsterdam FSA Hoewel bij deze uitgave de uiterste zorg is nagestreefd kan voor de aanwezigheid van eventuele (druk)fouten en andersoortige onvolledigheden niet worden ingestaan en aanvaarden de auteur(s), redacteur(en) en uitgever in deze geen aansprakelijkheid. Alle rechten voorbehouden. Niets uit deze uitgave mag worden verveelvoudigd, opgeslagen in een geautomatiseerd gegevensbestand, of openbaar gemaakt, in enige vorm of op enige wijze, hetzij elektronisch, mechanisch, door fotokopieën, opnamen, of enige andere manier, zonder voorafgaande schriftelijke toestemming van de uitgever. Inhoudsopgave VOORWOORD P. 4 A PRIMER ON WHOLE BUSINESS SECURITIZATION P. 6 THE ELUSIVE CREDIT CYCLE P. 14 DE VLOEK VAN DE WINNAAR SCHOKT DE FINANCIËLE WERELD P. 20 LIQUIDITY AND LIQUIDITY RISK IN THE CDS MARKET P. 30 THE CREDIT SPREAD PUZZLE P. 36 EXIT ABN AMRO: FUSIE VERSUS PRIVATE EQUITY P. 42 DE CRISIS OP DE KREDIETMARKTEN: WAT GING ER MIS EN WAT ZIJN DE RISICO S? P. 0 water earth fi re wind 3

3 VOORWOORD Introductie Amsterdam, Alfred Prevoo Credit Risk Management heeft de afgelopen jaren veel in de schijnwerpers gestaan, met als hoogtepunt het afgelopen halfjaar. De crisis die ontstaan is in Amerika waait langzaam over naar Europa, met alle gevolgen van dien. De heer Gerard Mertens, hoogleraar aan de Erasmus Universiteit Rotterdam, zal het ontstaan en de gevolgen van de huidige ontwikkelingen verder toelichten in het voorwoord: Tekst: Gerard Mertens De kredietcrisis houdt de gemoederen nu al ruim een half jaar bezig. Zijn oorsprong is te vinden in de Verenigde Staten, maar al snel heeft hij zich uitgebreid naar Europa en de rest van de wereld. Het meest recente probleem dat ik aantrof betreft wederom een Amerikaanse bank, te weten Citigroup. Terwijl ik dit voorwoord schrijf lees ik dat volgens een analistenrapport de bank niet meer kan voldoen aan haar kapitaalratio s en genoodzaakt is haar dividend naar beneden bij te stellen. De aandelenmarkten reageren opnieuw fors negatief. De angst voor grotere problemen gedeelte van de kredietmarkt. Toch zijn er twijfels, getuige het feit dat analisten van UBS minder positief zijn over de toekomst bij Fortis. Ook hier zijn zorgen over de eventuele gevolgen van de crises in de subprime markt aanleiding voor het negatieve sentiment. NIBC bank is een ander voorbeeld van een Nederlandse bank die enkele maanden geleden werd getroffen door de kreditecrises in de VS. In de ons omringende landen zijn de problemen echter groter, in het oog springende voorbeelden zijn Northern Rock (VK) en Deutsche Bank (Duitsland). doemt opnieuw op. De Amerikaanse economie staat er volgens een De gevolgen van de kredietcrisis voor Nederland lijken vooralsnog mee te vallen. De grote banken hebben in hun recente kwartaalberichten te kennen gegeven geen materiële gevolgen te ondervinden van de problemen in het subprime aantal vooraanstaande economen, waaronder Alan Greenspan (voormalig voorzitter van de FED) niet rooskleurig voor. Veroorzaker van al deze problemen is de huizenmarkt. Huizenprijzen dalen sind anderhalf jaar en ook het aantal nieuw

4 te bouwen huizen bereikte in oktober het laagste gevolgen van de problemen op de kredietmarkt te snel manifesteren. De toekomst zal ons leren in niveau in jaar tijd. Het einde van deze malaise voelen, getuige de eerder genoemde banken. hoeverre de huidige economische groei bestand lijkt nog niet in zicht. De pessimisten verwachten is tegen deze kredietcrises en of we we in staat dat ook de rest van de economie hierdoor ook Een veel gestelde vraag is of deze problemen zich zijn lering te trekken uit de gebeurtenissen op de zal worden geraakt. Als de Amerikaanse con- ook in ons land kunnen voordoen. Het antwoord kredietmarkt in het afgelopen half jaar. sument het laat afweten, door minder geld uit luidt dat die kans niet erg groot is. In de VS is te geven, wordt de belangrijkste pijler onder de het voor de lagere inkomensgroepen makkelijker Amerikaanse economie weggeslagen. Uitval van gemaakt om een hypotheek aan te vragen, dit is vraag kan de Amerikaanse economie daadwerke- het gevolg van bewust beleid van de Amerikaanse lijk in een recessie duwen. overheid. Dat klinkt mooi, maar wat te doen met Hoe zijn de problemen in de huizenmarkt ont- de hiermee gepaard gaande risico s? Welnu, de staan? Een mix van factoren zo kan worden ge- financiële wereld heeft hier een ogenschijnlijk steld. In de eerste plaats konden huizenbezitters fraaie oplossing voor bedacht. Door middel van jarenlang profiteren van de sterke waardestijging. nieuwe financiële producten (financial engenee- Ten tweede kon men meer gaan lenen doordat ring met een mooi woord) is het mogelijk de de rente in de afgelopen jaren uitzonderlijk laag risico s van bijvoorbeeld een portefeuille van een was en dus de lasten nauwelijks stegen. De hogere groot aantal hypotheken eerst te bundelen en ver- hypotheek en het daarmee vrijkomend kapitaal volgens weer op te splitsen in aparte stukken met werd grotendeels gebruikt voor luxe goederen- ieder een verschillende risicoprofiel. Wie bereid CV Gerard Mertens consumptie (auto s, vakanties en dergelijke), het- is meer risico te nemen krijgt ook een hogere Gerard Mertens is Full Professor of Financial geen goed was voor de economische groei. Door de stijgende rente en de dalende huizenprijzen vergoeding. De oorspronkelijke leningen wordt aldus opgeknipt en weer doorgeplaatst aan derde Analysis at RSM Erasmus University and research fellow of ERIM, the RSM Erasmus komen veel huizenbezitters plots in de proble- partijen (andere banken, verzekeraars, instituti- Research Institute. He received his masters men. In de eerste plaats doordat zij niet meer onele beleggers). Zo zijn delen van deze porte- degree in applied economics from Radboud kunnen voldoen aan hun maandelijkse betalings- feuilles in de afgelopen jaren bij vele verschillende University and holds a PhD in accounting from verplichting. Dit doet zich het sterkst voor bij de partijen over de hele wereld terecht gekomen. De Maastricht University. economisch zwakkere groepen in de samenleving. perceptie was echter dat de risico s van deze in- En als dan niet meer aan de betalingsverplich- vesteringen relatief laag waren, dat laatste blijkt He is currently chairman of the Department ting kan worden voldaan is men gedwongen nu onjuist te zijn. De risico s verbonden aan deze of Accounting & Control, which runs a master het huis te verkopen. Daar komt vervolgens het producten werden uit het oog verloren, wellicht program in accounting, control and financial probleem voor de hypotheekverstrekkers om de ook mede veroorzaakt door de complexiteit. In management. hoek. Leningen die zijn verstrekt kunnen niet dit verband kan ook de rol van de rating agen- meer worden afgelost en het huis dat als onder- cies worden genoemd, die niet adequaat hebben Prior to his appointment at RSM Erasmus pand geld, is sterk in waarde gedaald. Het zijn de gereageerd op het ontstaan van de problemen. University, he held appointments at Nyenrode instellingen met een grote exposure naar dit seg- Alhoewel het probleem dus van Amerikaanse Business School, Tilburg University and CentER, ment van de markt die als eerste de pijn voelden. origine is en de gevolgen wereldwijd merkbaar the Limperg Institute, University of Leuven and Maar ook de rest van de financiële sector bleek de zijn, zal dit zich in Nederland of Europa minder Maastricht University.

5 DE A PRIMER CRISIS OP ON DE WHOLE KREDIETMARKTEN: BUSINESS WAT GING SECURITIZATION ER MIS EN WAT ZIJN DE RISICO S? "Separation due to sale to an investment company, largely financed with debt, can be the optimal method to maximise the performance and value of the company or division." Tekst: Dr. Dennis Vink Since a number of years a new form of buy-out financing, the so-called whole-of-business securitization, has been successfully used in several Asian and European countries. With the help of this technique, Vodafone Japan recently securitized its assets in the largest securitization transaction ever: $12 billion. With this new form of financing a securitization, structure is used which makes it possible to finance the buy-out with a substantial amount of debt with long maturities and favourable credit ratings. Due to flexibility in the financing terms, this high leverage does not obstruct the necessary expansion investments for the buy-andbuild strategy. This form of financing is used by companies with predictable cash flows. Given the generally limited level of understanding of why and how business securitization creates value, this article aims to introduce the reader to the structural features of this relative new financing technique.

6 Introduction (hereafter: LBO). The financial pressure realised Whole-business securitization can be defined as In the last ten years many companies have deve- can be used to create more shareholders value by a form of asset-backed financing in which ope- loped shareholder value by using now well known motivated management than would be held pos- rating assets are financed in the bond market via restructuring methods, like the spin-off, equity sible under the situation of public property. a bankruptcy-remote vehicle (hereafter: SPV) 1 carve out, and issue of tracking stock. Especially and in which the operating company keeps com- business units that are in competition in new, fast The decision to use whole-business securitiza- plete control over the assets securitized. In case growing trade sectors where the big money is tion involves an explicit choice regarding the of default, control is handed over to the security earned after several years primarily use these me- financial structure concerned as well as mana- trustee for the benefit of the note holders for the thods. The new established companies inherit in gerial involvement and control. The intention of remaining term of financing.2 general a low debt burden of the parent company this article is to get the reader acquainted with because in the coming years the incoming cash the financing terminology whole business se- One of the great challenges lies in defining the flows are to be used for financing further expan- curitization, by which the elements that make difference between operating asset securitization sion. A high debt burden would endanger these whole business securitization attractive will be and the more common forms witnessed in secu- investment opportunities and therefore hinder explained in detail. ritization transactions. Consider for instance a the exercise of the utmost valuable real options. Moreover, a limited part of the enterprise value Whole Business Securitization mortgage pool. If the mortgages have been securitized, the seller (sponsor) has no further obli- contains solid assets, which will discourage the Definition gations towards the consumer. The mortgage has providers of debt holders: in case of liquidation Whole-business securitization uses securitization been closed and stipulations concerning future the sale will gain little value. techniques for refinancing a whole business or payments to be made by the consumer have In sectors with a low turnover growth, constant operating assets. You may wonder what exactly is meant by whole business, and where precisely the been laid down in a contract. Simply stated, the financial institution then collects payments from 7 margins and correspondingly stable cash flows, difference lies compared with the more usual ty- the consumer for the balance of the life of the above-mentioned restructuring techniques are pes of collateral used in securitization transactions: loan. In effect, the traditional classes of securi- of less value. In said sectors the advantages of a credit cards or mortgages, for example. In order to tization assets are self-liquidating. By contrast, stock listing are mostly limited and do not weigh make you understand whole-business securitiza- in the example in which claims on the basis of up to the costs involved. Separation due to sale tion, its definition will be presented first. Next, the operating assets are securitized, the sponsor has to an investment company, largely financed with difference will briefly be explained between whole- an obligation to exploit the underlying assets. To debt, can be the optimal method to maximise the business securitization and the more common offer an illustration: when a football club secu- performance and value of the company or divi- forms of securitization as we know them today: ritizes its revenues from the sale of tickets, the sion. Thanks to the predictable cash flows these for example the use of mortgages and credit cards. sponsor must continue to render services that companies generate, a high finance burden is of- allow football fans to buy their tickets at the box ten possible, hence the name leveraged buy out office. Thus, the securitization process requires permanent managerial involvement on the part 1 Securitization vehicle, also called a special purpose vehicle, established only for the purpose of a specific securitization and legally different and independent from the original owner of the assets. The securitization vehicle has a different governance structure than the originating firm. In particular, its specific structure restricts any chance of a standard bankruptcy procedure. 2 It is essential that the SPV receive the strongest possible rights over all the assets needed to operate (or sell) the business, of the original owner in order to generate revenues. The element of future exploitation of the asset is a key distinction between standard securitization and operating-asset securitization. should a default arise.

7 DE CRISIS OP DE KREDIETMARKTEN: WAT GING ER MIS EN WAT ZIJN DE RISICO S? "Formerly most pubs were associated with large beer producers who introduced themselves of sale by exclusive contracting, by which the pubs were obliged to sell only one brand of beer." Secured loan structure cern rather than being forced to have a fire sale finally agreed to pay all classes of bondholders In a standard whole-business securitization of the individual assets. This preserves the value back at par by selling nine service stations. transaction, a financial institution grants the sponsor a loan secured by a pledge on a specific of the assets securitized, which is of great importance to the investors. Whole-business securiti- Credit rating improvement set of assets. This secured loan is then transferred zation therefore efficiently uses the privileges of The result of bankruptcy remoteness is that the to a bankruptcy-remote special purpose vehicle bankruptcy law offering bondholders extensive SPV generally issues securities that are rated hi- which issues the notes. The security attached to security in case of default. gher (and in many cases significantly higher) in the loan is also transferred to the SPV. Thus, ownership and control of the assets remain with the Receivership in default: case of comparison with other alternatives, such as the issuance of ordinary secured debt by the company. sponsor, and bondholders are only granted charge Welcome Break This is the result of the risk mitigation generated over those assets. Control is required because the A clear case of effective receivership in default by isolating the assets from the bankruptcy and 8 owner of the assets should exploit the assets for the full term of financing. Also, the sponsor in- is that presented by Welcome Break, the U.K.- based motorway service area operator and the other risks of the parent company through the whole-business securitization structure. Hence, tends to repay the loan out of the cash flows ge- first whole-business securitization operation the holder of an asset-backed bond is in a po- nerated from its business. in its segment. When Welcome Break was no sition similar to that held by the holder of an Bankruptcy remoteness longer able to meet its obligations following its weaker-than-expected operating performance in ordinary secured bond with regard to the sponsor, because repayment of the bonds takes place from In case of default of the sponsor, the SPV re- 2002, the owner was in danger - if the economy a defined pool of assets. The difference is that the ceives complete control over the securitized as- continued to slide of landing in a situation in holder of an asset-backed bond is not affected by sets by appointing a receiver for the full term of which the company would not be able to meet its the non-performance of the sponsor s other as- financing. The receiver has authorization to seize debt obligations. The owner then made an offer sets, whereas the ordinary bondholder is. control over the assets of the securitized business at the loss of any other creditor. Also, the to the bondholders: Class A s were to be repaid at par ( 309 million par value), and Class B s at % Law in the Netherlands receiver eliminates the risk of external activities ( 67 million par value). This was rejected by the Control over the cash flows of the securitized of management decisions reducing the return to bondholders. Subsequently, after Welcome Break business is established either through a sale of bondholders. This is called bankruptcy remo- failed to make full payment on its loan, it was put the assets, or through an adequate legal struc- teness. The SPV increases the likelihood of the into receivership. Deloitte was appointed admi- ture that ensures continuation of cash flows in business being able to continue as a going con- nistrative receiver. A few days later, the owner the event of the insolvency of the borrower. This

8 feature makes it difficult in some countries to creditors. Does this then imply that such things explain the securitization transaction of Punch structure a business securitization deal. In fact, it could not occur in the Netherlands? On the Taverns in 1998 in some detail, given the fact has been proven to be hard to separate the assets contrary: France, Belgium and Germany have that it s the first pub deal to get underlying tri- legally while the sponsor still retains operating encountered similar problems. In these countries, ple-a ratings from both S&P and Fitch. control and services these assets. Under U.K. law, this difficulty has almost been eliminated by the a series of large transactions has recently been witnessed in which the role of the receiver and LBO 1986 Insolvency Act, which permits the holder securing the pledge in default cases have been In 1997 Grovebase Ltd in cooperation with in- of a charge over substantially all of the assets of adequately and appropriately dealt with. vestment company BT Capital partners (hereaf- a corporate to control the insolvency proceeds of that corporate through an administrative receiver. 3 Case Punch Taverns: Securitization Pioneer Creates Finance Template ter: BT) acquired 1,400 pubs from conglomerate and beer brewer Bass Ltd through a LBO. The pubs, which are mainly managed by independent Unfortunately, in the Netherlands no whole- Background In the pub industry many whole business secu- entrepreneurs, were placed under Punch Taverns. All are obliged to buy beer from Punch Taverns, business deals have so far been finalized that ritizations took place at the end of the nineties. by which Punch could stipulate favourable con- could act as an example. One of the reasons for This was also due to the vertical disintegra- ditions with beer suppliers in favour of the as- this is presented by the role played - and the tion enforcement by the British Government. sociated pubs. This means that the pubs could responsibilities held - by the receiver in a ban- Formerly most pubs were associated with large buy more than one brand of beer and sell a wide kruptcy case. If it involves a bankruptcy situ- beer producers who insured themselves of sale range of brands to the consumer. About 60% of ation, the receiver has extra powers. He may, by exclusive contracting, by which the pubs were the income of Punch Taverns comes from the for instance, in certain situations nullify specific obliged to sell only one brand of beer. It was an sale of beer, and about 40% from rent. Soon after obligatory juristic acts: for example if both the eyesore to the government. The large beer com- the purchase, the shareholders wanted to replace debtor and the third party involved knew that a panies were forced to sell their pubs in the hope the acquisition financing by cheaper, more tra- bankruptcy petition had already been filed, or if of improving competition and thus increasing ditional alternatives with a variety of vehicles the case involved collusion between the credi- the quality in the pub industry. Although it is ranging from syndicated loan to tapping the tor and the debtor to the detriment of the other not the first business securitization, I choose to high-yield market. However, lower financing costs, the desire of long-tenor financing and the 3 These privileges are based on the very favorable insolvency regime operated in the U.K. which allows the so-called fixed and floating charges of a corporate to be passed over to a specific creditor. This passing of the fixed and floating charges can be identified need for operational flexibility encouraged the shareholders to turn to business securitization. as the main value drivers in a business securitization transaction.

9 DE CRISIS OP DE KREDIETMARKTEN: WAT GING ER MIS EN WAT ZIJN DE RISICO S? Secured loan structure Punch Taverns (hereafter: Punch Holding) financed the acquisition of the pubs. To structure the securitization, BT established a SPV named Punch Finance SPV (hereafter: Punch SPV) and was incorporated as a subsidiary of Punch Holding and a sister company to Punch Operating Company (hereafter: Punch Co). Punch SPV then issued tranches of fixed and floating notes and a liquidity facility to support over the pubs for the full term of the remaining financing. Furthermore, Punch Co. concluded a contract with the Management Company for managing the pubs. The following figure (figure 1 below) shows a graphic of the legal structure of the Punch Taverns transaction. Financing structure Punch SPV issued the following debt: five debt tranches with a fixed and floating interest with a Lessons from Punch Taverns When comparing the original acquisition financing with whole business securitization, it obviously appears that the orginator realised considerable savings in financing costs. Table 3 shows that the leverage increased, the average interest costs declined, whereas the maturity appeared longer. the credit rating for the notes. The proceeds were advanced by Punch Finance as an inter-company loan to Punch Co. The inter-company loan was collateralised by all assets of the company. Punch Co. applied the proceeds to repay the acquisition loan and a portion was made available to finance future capital expenditures requirements. The inter-company loan is serviced by Punch Co. s ability to generate cash flows regardless of source, in what is effectively a future-flow transaction. This means that the future cash flows of Punch Co. are primarily used to pay the obligations of Punch variety of maturities up to 28 years, and a liquidity enhancement of 60 million pounds. This so-called enhancement is used to meet the obligations of bondholders in time, instead of being forced to liquidate pubs in case of temporarily liquidity shortage. Figure 1: The secured loan structure of Punch Taverns Secured loan structure Security package Punch Holding SPV. Moreover, Punch SPV has a senior claim on the securitised assets in case of bankruptcy of Punch Finance SPV Punch Operating Company Management Company Other BU BU Punch Holding, and Punch SPV could defeat all claims of possible creditors of Punch Holding. Bondholders In short, Punch SPV acquires complete control

10 Table 1: Financing structure of Punch Taverns before and after whole business securitization Original acquisition financing Whole business securitization mln % EBITDA mln. % EBITDA Multiple Multiple Senior 320 3% 4.x Floating rate notes 10 year 120 High yield % 1.x Floating rate notes 13 year 60 Bridge Floating rate notes 17 year 80 Fixed rate notes 2 year 17 Fixed rate notes 28 year 100 Total debt % 6.0x Total debt 3 89% 7.x Equity % 2.4x Equity 6 11% 0.9x Total % 8.4x Total % 8.4x Source: BT Alex Brown (1998) The debt issued has a certain amount of built-in flexibility because all floating rate notes are callable. The following summary shows the other characteristics of debt with different maturities. Table 2: Financing structure of Punch Taverns debt Tranche Size Credit rating Interest Floating rate notes 10 year 120 A2 L + 6 Floating rate notes 13 year 60 A2 L + 7 (1-10 year), hereafter L Floating rate notes 17 year 80 A2 L + 9 (1-10 year), hereafter L Fixed rate notes 2 year 17 Baa/BBB 7.27% Fixed rate notes 28 year 100 Baa/BBB 7.7% Source: BT Alex Brown (1998) Table 3: Comparison between the original acquisition financing and whole business securitization Original acquisition financing Whole business securitization Takeover sum 600 m 600 m Debt 430 m 3 m Average Cost of Funds L % L % Maximum maturity 11 years 28 years Total Debt to Free Cash flow.9x 7.3x Debt Service Coverage Ratio 1.x 1.8x Source: BT Alex Brown (1998)

11 DE CRISIS OP DE KREDIETMARKTEN: WAT GING ER MIS EN WAT ZIJN DE RISICO S? "A combination of too little return on investment and too high leverage damaged the sponsor to such an extent that it was ultimately forced to make repayments to the investors by winding up the business." Important lessons can be learnt from the securitization of Punch. Although it took a lot of time to successfully complete the financing structure for all parties involved, in the end the gain in reducing the financing costs was considerable. Obviously, both investors and credit rating agencies needed time to get acquainted with a new class of debt paper, a new way of financing and a new sector. Because of the unfamiliarity, it appears to be of great importance to fall back on the original bridge financing with a long maturity in such a way that the investment company is granted time to establish an optimal structure and sell the paper at attractive conditions. Just with the issuance of the long term debt obligations with a less favourable credit assessment the issuer would be dependent on the whims of investors along strongly fluctuating risk- and liquidity premiums for different maturities. Conclusion Whole business securitization resembles the familiar forms of asset-backed in various ways. The total issued debt is a high percentage of the value of the homogeneous assets, the debt is tranched to meet the demands of investors, and the debt is issued by a bankruptcy-remote SPV. Because it concerns the securitization of operating assets, it is crucial to recognise that management is in the best position to take operational decisions and to leave operating matters to their discretion subject to general controls regarding the interest of bondholders. Just like the other forms of assetbacked, investors prefer a transparent structure by refinancing a homogeneous group of assets of which the business risk is perceived as low. A whole business securitization is then only a financing alternative for a buy-out or public-to-private transaction when the operations are considered to be a homogeneous portfolio of assets that will generate a predictable cash flow for the long term.

12 Applying such structures, however, is not without innovative and successful transactions that have References risks: witness the problems encountered in the so far taken place in neighboring countries. Think BT Alex Brown, Public and Private Market Welcome Break transaction. A combination of about airports, for example, or hospitals, motor- Financing Instruments in Acquisition Financing, too little return on investment and too high le- way restaurants, entertainment parks, movie thea- Conference European Acquisition Finance, verage damaged the sponsor to such an extent that it was ultimately forced to make repayments tres or royalties paid to famous Dutch artists. And how about revenues generated by the many major References to the investors by winding up the business. Still, football clubs operating in our country? many enterprises have so far been eager to use the Dr. Dennis Vink lectures Corporate Finance in whole-business securitization technique in order Research into the possibilities of setting up secu- the MSc, MBA and executive education programs to enjoy the advantages offered by cheaper finan- ritization structures, into the opportunities that at Nyenrode Business Universiteit, Breukelen. In cing in combination with longer terms. will be generated and into calculating the profits addition, Dennis acts as an independent business to be gained by individual businesses will have advisor, covering a wide range of disciplines in the The structure discussed here will undoubtedly to demonstrate whether this techniques is worth field of structured finance. evolve over time and adapt to changing market applying. conditions. Many Dutch firms could definitely benefit from repaying their perhaps needlessly complex, but certainly expensive bank loans taken out with various lenders and from replacing them by a transparent and straightforward securitization transaction structure witness the highly

13 DE THE CRISIS ELUSIVE OP CREDIT DE KREDIETMARKTEN: CYCLE WAT GING ER MIS EN WAT ZIJN DE RISICO S? Tekst: André Lucas VU University Amsterdam Modeling systematic risk in credit portfolios is very important. Our understanding of the nature of this systematic risk, however, is still limited. One explanation relates credit cycles directly to business cycles indicators. The prima facie plausibility of this relationship, however, is challenged by recent empirical research. Credit cycles appear to also have their own separate dynamics, and the dynamics may be substantially different across different industries and different types of credit risk. This may have obvious important implications for credit risk assessments and capital requirements. The basics of systematic credit risky products has become a major industry. credit risk. Second, however, it is important to credit risk Instead of taking on credit risky loans directly take the possibility of joint default events into Credit risk is one of the major sources of risk in on the balance sheet, large institutional investors account. Here, one can think of events at the the financial industry. Naturally, credit risk has a nowadays have easy access to credit risk by, for macro or industry level that affect a whole set 14 very long history. There has, however, been a real surge of interest due to developments in financial example, creating an overlay on a risk free government bond portfolio using credit derivatives of counterparties simultaneously. For example, changes in taxes or regulations might affect the markets (new products, new markets) and subse- like (portfolio) credit default swaps. Liquidity in profitability and thus the creditworthiness of an quent changes in the regulatory system. these markets has increased considerably, and entire industry. Alternatively, defaults might be The importance of our understanding of credit standardization for portfolio derivatives has also contagious. For example, the default of a major risk has been underlined by the sub-prime mar- reached a mature level. car producer might also increase the credit risk ket crisis in the US earlier this year. Defaults are Because of the increased trading possibilities and of some of its suppliers and vendors. important. They need not be limited to individual re-packaging possibilities for credit risk, it beco- In short, credit risk is often decomposed into two households or counterparties, but can affect a large mes also increasingly important to keep track of driving sources: idiosyncratic or firm-specific cre- chunk of an economy simultaneously. Moreover, the ultimate sources of risk such exposures cre- dit risk on the one hand, and systematic credit the current range of credit risk products that are ate for large institutions. Two issues are of prime risk on the other. To illustrate the crucial dif- actively traded on markets allow parties to take importance. First, the expected level of credit risk ferences between these two, an over-simplified on credit risk directly and efficiently, but it may is important. Familiar notions here are the de- example is helpful. Assume we have a bucket also complicate tracking where the big credit risks fault or downgrade probability of an individual full of six-faced dice. We throw every dice in the finally end up. counterparty, the exposure to the counterparty in bucket separately. If the result of this throw is 2 Given the development of credit markets over case of default, and the loss one incurs at default. or less, we pay 1 Euro. Otherwise, we receive 60 the last few years, packaging and re-packaging of Increases in any of these variables increase the cents. The expected pay-off in this experiment is

14 "Given the development of credit markets over the last few years, packaging and repackaging of credit risky products has become a major industry." 6.7 cents (per dice). If there are 1000 dice in the other hand, reflects the systematic component of the literature confirms this point of view. The typical bucket, the pay-off of the whole experiment lies credit risk. If we increase the number of dice in line of thought is that in an upward phase of the between 9 and 13 Euro with 99% probability, each bucket, the range of possible outcomes as a business cycle, the number of defaults increases. By with an average of Euros. percentage of the maximum loss converges to the contrast, if the economy heads into a recession, the Now consider a complication of the experiment. expected loss for each bucket (-6.7% for heads, number of defaults increases. Empirical supportive Before we throw our 1000 dice, we first perform and +60% for tails). So, whatever the size of the evidence is found in papers by Nickell et al. (2000) a coin flip. If heads shows up, we take the above credit risky portfolio (bucket), the credit risk re- and Bangia et al. (2002), amongst many others. bucket with 1000 dice. However, if we see tails, mains stochastic due to the presence of a syste- The approach usually taken in the empirical lite- we take an alternative bucket. The 1000 dice in matic risk factor (the coin flip). This risk cannot rature is to include typical business cycle proxies this alternative bucket are four-faced and, mo- be diversified. Or even better, for large portfolios, as explanatory variables for corporate default rates. reover, have faces with 0, 1, 2, and 3 holes. We still pay 1 Euro if we have 2 holes or less, and the systematic risk is the prime most important driver of credit risk, much more than the firm- One can think of GDP growth rates, NBER business cycle indicators, slopes of the term structure of 1 receive 60 cents otherwise. In this more elaborate specific credit risk. Because of this, two simple interest rates, and many more. A stylized fact is that experiment, the 99% confidence range of pay-offs questions become immediately relevant: (1) what the correlation between default rates and business of the experiment crucially depend on the initial is the size of this systematic risk, and (2) what is cycles is negative: business cycle troughs and default coin flip. For heads, the range is a gain of 9 to the nature of this systematic risk. Regarding the peaks cluster together. 13 Euros. For tails, however, the range is a loss answer to question one, we need an impression of Though in line with common intuition, this strand between 40 and 66 Euro. the clustering of defaults. Various methods have of the empirical literature skips the important is- The mechanics of this simple experiment resem- been put forward for this, and we abstract from sue of possible mis-specification in the dynamics of ble those of most credit risk models used in the an elaborate discussion on this issue here. Instead, corporate default rates. In particular, if we hypothe- academic literature and in the industry. Every dice we focus on the answer to the second question. size that credit cycles and business cycles might not can be interpreted as an individual counterparty, and the bucket as a credit risky portfolio. The one Business cycles and credit risk coincide, the significance of business cycle proxies in earlier work could just be the result of an omitted Euro loss is the loss on one exposure in case of Given the non-diversifiable nature of systematic (correlated) regressor that has its own dynamics. If the credit event. If there is no credit event, a gain credit risk, it is tempting to think of the general eco- we would be able to find a better proxy for the true is realized. The throw of a dice therefore reflects nomic climate captured by the business cycle as the credit cycle, the significance of the earlier business the firm-specific credit risk. The coin flip, on the driver of systematic credit risk. A casual reading of cycle proxies might disappear automatically.

15 DE CRISIS OP DE KREDIETMARKTEN: WAT GING ER MIS EN WAT ZIJN DE RISICO S? "Systematic credit risk dynamics appear to have a much more subtle dynamic pattern than explained by business cycle dynamics." New classes of credit risk models To address the above issue, new classes of credit risk models have been developed, see for example Koopman et al. (2006, 2008) and Das et al. (2007). These models do not only allow for the typical business cycle proxies to capture systematic credit risk dynamics. In addition, they allow for a separate, unobserved credit cycle. The models are more difficult to estimate, but also allow one to address a wider set of hypotheses. In particular, they capture the optimal credit cycle directly from the data using the clustering pattern in defaults and upgrades and downgrades in quality. For example, in Koopman et al. (2006), we allow for a wide variety of economic variables to explain variations in default rate dynamics. Apart from the regular business cycle proxies, we also look at bank lending conditions and general capital market conditions as possible alternative explanations for clusters of defaults. Interestingly, in a traditional modeling framework, many of these variables turn out to be significant with intuitively plausible signs. GDP growth, e.g., has a negative impact on defaults rates, while stock market volatilities have a positive impact on defaults, but a negative impact on upgrades. If one allows for the possibility that default rate dynamics are mis-specified by including a separate credit risk cycle into the model, however, many of the earlier significance results disappear. Put differently, the new credit risk cycle drives out many of the traditional macro variables as plausible descriptors for systematic credit risk dynamics. A similar result is found by Das et al. (2007). To illustrate the findings, consider Figure 1 as taken from Koopman et al. (2006). The figure displays the optimal scaled version of (negative) GDP growth and the optimal estimate of the true credit cycle based on the new class of models. We see that there is a clear correlation between the two cycles, for example the peaks 1991, 1996, However, there are also obvious points of departure, even if we abstract from the earlier years Most striking is the increase in systematic credit risk during the internet bubble , whereas GDP growth during this period is rather stable. Also the difference towards the end of the sample indicates that GDP growth may fall back, while systematic credit risk is still decreasing. To pursue this line further, Koopman et al. (2008) decompose US default rates further across different industries using a similar methodology. The most important additional result of that paper is that the timing and magnitude of systematic default risk may also differ between industries. Though there is a common component similar to Figure 1 in all industries, the finance industry has an additional peak of defaults in the late 1980s, the utilities industry in the early 1980s, and the high-tech industry in the late 1990s. Default dynamics appear not only driven by the general economic climate, but also by industry specific factors. To complicate issues even more, the dynamics also appear different between different types of credit risk. The default risk factor in Figure 1 is significantly different from the systematic downgrade credit risk factor, which, in turn, is different from the systematic factor that explains upgrades, see Koopman et al. (2006). Summarizing, systematic credit risk dynamics appear to have a much more subtle dynamic pattern than explained by business cycle dynamics. This leads us to a discussion of a possible theoretical explanation for this result and the consequences for empirical risk management and capital buffer formation at financial institutions. A possible explanation and implications for credit risk management The separate dynamics of credit risk and the business cycle call for a theory to explain these empirical findings. One important lead is given by Gorton and He (200). They consider an imperfectly competitive banking industry, where banks can also compete by setting their lending standards. This endogeneity in bank lending standards causes a separate set of dynamics in

16 Figuur 1: Scaled (negative) GDP growth (blue dotted) and the credit cycle (red solid) bank lending and bank losses, irrespective of the namics of credit risk may be different across indu- Alternatively, multi-factor models might reflect business cycle. stries, across rating movements, and across global possible diversification possibilities better than in The endogeneity of bank lending conditions has regions. Restricting the regulatory attention to the one-factor regulatory benchmark model. also been studied elsewhere and proven impor- only a simple one-factor model may then be over- Finally, the endogeneity of lending conditions tant for financial stability, see also some of the simplified and cause a second wave of undesired may be a mechanism by which banks partly cause other papers in this issue. The implications for regulatory arbitrage. In the first wave, the focus their own clusters in defaults. If this is true, we practical risk management and for financial sta- was on the possible mismatch between regulatory are back at the well-established Lucas critique. bility are threefold. and real world levels for the default probabilities. In this case, we should not work with simple re- First, the current generation of risk models may These incentives have largely been removed by duced-form econometric models for credit risk not adequately reflect the credit risk in portfolios. a more flexible internal modeling approach. The management, but try to better model the deep Models based on macro predictors may miss out prescriptions for the clustering of defaults, ho- parameters of the credit extension process and on some important dynamic properties of defaults. This can cause severe underestimation of wever, is still rather rigid. This might motivate financial institutions to try to arbitrage this part their consequences for aggregate risk dynamics. This might in the end evolve into a better un- 17 the credit risk of a portfolio at horizons of 1 to of the regulatory framework. This can be done derstanding of the dynamics of this important years, see also Das et al. (2007). by empirical models and products that better re- risk factor, and thus contribute to more financial Second, the typical one-factor models used in the flect the dynamics of the systematic credit risk stability. regulatory context may only provide a very rough and therefore allow one to better time periods reflection of the complexity of credit risk. The dy- of increased or decreased clustering in defaults. References Bangia, A., F. X. Diebold, A. Kronimus, C. Schagen, and T. Schuermann (2002): Ratings migration and the business cycle, with applications to credit portfolio stress testing, Journal of Banking & Finance 26, Das, S.R., D. Duffie, N. Kapadia, L. Saita (2007): Common Failings: How Corporate Defaults Are Correlated, The Journal of Finance, 62(1), Gorton, G.B., and P. He (200): Bank Credit Cycles, NBER working paper. Koopman, S.J., R. Kraeussl, A. Lucas, and A. Monteiro (2006): Credit Cycles and Macro Fundamentals, Tinbergen Institute Discussion paper TI06-023/2. Koopman, S.J., and A. Lucas (2008): A Non-Gaussian Panel Time Series Model for Estimating and Decomposing Default Risk, Journal of Business and Economic Statistics, forthcoming. Nickell, P., W. Perraudin, and S. Varotto (2000): Stability of rating transitions, Journal of Banking & Finance 24,

17 DE CRISIS VLOEK OP VAN DE DE KREDIETMARKTEN: WINNAAR SCHOKT WAT GING DE FINANCIËLE ER MIS EN WERELD WAT ZIJN DE RISICO S? "Een kleine verstoring aan het begin van de berekening bleek tot grote verstoringen verderop in het model te leiden. Het was alsof de vlucht van een vlinder ergens in het Braziliaanse oerwoud na een aantal dagen een flinke stormdepressie op de Noordzee tot gevolg had." Tekst: Frank A.G. den Butter en Bernard Compaijen ¹ Dit artikel bespreekt vanuit een algemeen economisch perspectief de risicospreiding op de financiële markten. De puzzel is dat te verwachten valt dat risicospreiding als schokdemper werkt terwijl bij de crisis met de subprime hypotheken van augustus 2007 de ver doorgevoerde spreiding van risico s juist tot een schokversterking heeft geleid. Het antwoord is dat de partiële, op individuele afwegingen tussen risico en rendement gerichte analyses, geen rekening houden met de fallacy of composition die op macroniveau bestaat. Vanuit dit gezichtspunt is het vooral de vloek van de winnaar die tot schokversterking aanleiding heeft gegeven. Deze vloek houdt in dat die beleggers die de risico s van de beleggingen het laagst hebben gewaardeerd, er de hoogste prijs voor hebben betaald. Op macro-niveau ontstond daardoor een onhoudbare situatie omdat de beleggingen in hun totaliteit het gewenste rendement niet konden opbrengen. 1 Beide auteurs zijn Hoogleraar Algemene Economie Vrije Universiteit Amsterdam.

18 Inleiding gaan naar de boosdoeners die voor schokverster- tisch het gedrag op macro-niveau behoeft weer De crisis die de financiële wereld rond augustus king op de financiële markten zorgen. De chaos- te geven. Aangezien deze beschouwingswijze uit 2007 trof, doet denken aan het verhaal van de theorie is vooralsnog niet echt bruikbaar om de de algemene economie nog weinig aan bod is vlinder van Lorenz. Edward Lorenz is een in de doorwerking van schokken in de economie te gekomen in de analyse van financiële crisissen, meteorologie terecht gekomen wiskundige die begrijpen (zie De Wolff, 1990). Vandaar dat wij gaat het vervolg van dit artikel hierop wat die- in door hem opgestelde computermodellen voor in dit artikel pogen vanuit onze eigen discipline, per in. Vanuit dit perspectief worden 4 mogelijke de atmosferische circulatie vreemde uitkomsten de algemene economie, de oorzaken te achter- boosdoeners onder de loep genomen, namelijk (i) kreeg. Een kleine verstoring aan het begin van halen van de schokversterking, die het probleem de rentestijging en de daarmee samenhangende de berekening bleek tot grotere verstoringen ver- met de hypotheken in de VS teweeg bracht. Dit daling van de huizenprijzen in de VS, (ii) de se- derop in het model te leiden. Het was alsof de algemeen economisch perspectief biedt een meer curisatie van de risico s waardoor deze op soms vlucht van een vlinder ergens in het Braziliaanse omvattend beeld dan wanneer uitsluitend vanuit ondoorzichtige wijze over vele financiële instel- oerwoud na een aantal dagen een flinke stormde- de financiële beschouwingswijze naar de crisis lingen zijn verspreid; (iii) de moral hazard die op pressie op de Noordzee tot gevolg had. Iets derge- wordt gekeken. Bovendien wordt hierbij conse- verschillende plaatsen in het financiële systeem lijks lijkt zich rond augustus 2007 in de financiële quent vanuit het beginsel van de economische van belang is en waarmee bij de inrichting van wereld voor te doen. Een aantal hypotheekban- rationaliteit geredeneerd. voorzieningen rekening gehouden moet worden; ken in de VS die risicovolle hypothecaire leningen zogenaamde subprime mortgages - hadden Inhoud en (iv) de vloek van de winnaar waarbij de hypothese is dat bij een verschillende inschatting 21 verstrekt, raakten in de problemen omdat hun In eerste instantie lijkt de manier waarop de van de risico s diegenen eigenaar van de risico s schuldenaren de lasten van hun hypotheken niet hypotheekschok zich voortplantte, even raadsel- worden die de laagste inschatting maken en dus meer konden opbrengen. Deze naar verhouding achtig als bij de vlinder van Lorenz. Immers, de bereid zijn de hoogste prijs (= de laagste risi- betrekkelijk kleine schok, zij het iets groter dan risico s van de hypotheekverlening zijn via allerlei copremie) voor de financiële risicoproducten te de vleugelslag van een vlinder, verspreidde zich constructies en innovaties wereldwijd over finan- betalen. Dit laatste aspect heeft in de analyse van als een olievlek over de financiële wereld en werd ciële instellingen gespreid. Men zou denken dat de crisis vooralsnog weinig aandacht gekregen. steeds omvangrijker. deze risicospreiding veeleer als schokdemper dan Vandaar dat dit artikel wat verder inzoomt op als schokversterker zou fungeren. Daarom stelt dit aspect en daaraan ook zijn titel ontleent. Het De kuren van het computermodel van Lorenz dit artikel zich eerst de vraag welke fundamen- toezicht op de financiële instellingen vervult een leidden tot de ontwikkeling van de chaos-theorie tele redenen er voor deze contraire en contra- belangrijke rol om de doorwerking van schokken waar zogeheten vreemde aantrekkers als boos- intuïtieve reactie kunnen zijn. Hierbij komen de tot een crisis en chaos op de financiële markten te doeners voor het ontstaan van chaos werden onvolledigheid van informatie en de zogeheten voorkomen. Besproken wordt in hoeverre dit toe- aangemerkt. Nu is chaos een toestand die koste fallacy of composition in aanmerking. De fal- zicht er verder op kan worden toegespitst om de wat kost op de financiële markten vermeden dient lacy of composition geeft aan dat de som van het mechanismen die tot schokversterking aanleiding te worden. Daarom is het van belang op zoek te op micro-niveau beschreven gedrag niet automa- geven zo veel mogelijk te neutraliseren.

19 DE CRISIS OP DE KREDIETMARKTEN: WAT GING ER MIS EN WAT ZIJN DE RISICO S? Daarbij draagt de hulp die de centrale banken gegooid. Verzekeringsmaatschappijen hebben veel Verzekeringsmaatschappijen spreiden via een on- hebben geboden om de financiële wereld uit de ervaring in het juist inschatten van risico s. Zij zul- derlinge uitwisseling al sinds jaar en dag hun risico s, problemen te helpen en waardoor de crisis len de verzekeringspremie ook alleen dan verho- en weten dat steeds beter en op grotere schaal te zich vooralsnog als zeer mild heeft gemanifes- gen wanneer er een trendmatige stijging van de doen (zie Lucas, 2002). Dit systeem werkt (ken- teerd een kiem voor nieuwe problemen in de schadebedragen (ten opzichte van het verzekerde nelijk) ook uitstekend als schokdemper. Grote ram- toekomst in zich. Tot slot worden de bevindingen bedrag) aantoonbaar is. Hier geldt zelfs de verze- pen met veel schade zijn vooralsnog goed door het van dit artikel samengevat. keringsparadox (zie Hinloopen, 2007). Het feit systeem opgevangen en hebben niet geleid tot een Risicospreiding als schokdemper De kern van het probleem is de manier waarop dat zich af en toe schade voordoet, is nodig voor het bestaansrecht van de verzekering. Wanneer er geen schade meer zou zijn, zou niemand zich wereldwijde crisis van verzekeringsmaatschappijen. Waarom gaat het dan niet goed bij de risicospreiding van de risicovolle leningen zoals de subprime de spreiding van risico s in de financiële wereld willen verzekeren. Iets dergelijks geldt in de fi- mortgages? Ten dele heeft dit te maken met de plaatsvindt. Daartoe dient eerst aangeduid te wor- nanciële wereld. Wanneer risicovolle beleggingen andere doelstelling van de risicospreiding in de fi- den wat onder risico wordt verstaan. Een risico en durfkapitaal niet af en toe met een oninbare nanciële wereld. Het eigendom van de risico s wordt heeft twee dimensies, namelijk (i) de kans dat een schuld worden geconfronteerd, zou er ook geen hier doorgegeven om een zo hoog mogelijk rende- gebeurtenis met (negatieve) financiële gevolgen reden zijn voor een hoog te verlangen rendement ment te behalen met, vanuit het perspectief van de zich voordoet en (ii) de omvang van het (negatie- op dergelijke beleggingen. De risicopremie kent individuele beleggingsinstelling, zo min mogelijk ve) gevolg: de schade. Het bestaan van risico s be- twee componenten: (i) een extra rendement (ho- risico. Daarbij worden de vorderingen met risico s in tekent dat er sprake is van onzekerheid. Essentieel gere rente) om de uitval vanwege deconfiture te pakketjes samengevoegd, zodat deze verhandelbaar is dat het risico goed wordt ingeschat. Ten on- kunnen bekostigen, en (ii) een extra rendement zijn en buiten de balans van de financiële instelling rechte wordt ter verklaring van de crisis wel ge- vanwege de onzekerheid die inherent is aan het vallen die de risicovolle leningen heeft uitgegeven. steld dat met de deconfiture van de Amerikaanse kansproces van de risico s. De tweede component Dit maakt de vorderingen liquide. Vooral hedge hypotheekbanken het risico zou zijn toegenomen. staat centraal in de afweging tussen risico en ren- funds en investeringsbanken hebben deze pakketjes Dat is onzin, zoals de bewering onzin is dat bij het dement, en hier levert risicospreiding een voordeel in portefeuille genomen en op hun beurt weer door- gooien met een zuivere dobbelsteen de kans op een op omdat dit de volatiliteit in de rendementen verkocht. Het gevolg is een zeer gecompliceerd sy- 3 groter wordt wanneer men een keer een 3 heeft vermindert. steem waar moeilijk overzicht over te verkrijgen valt.

20 De economische theorie draagt twee fundamentele redenen aan waarom het in zo n systeem mis kan gaan, en waarom het systeem niet als schokdemper maar als schokversterker gaat fungeren. In de eerste plaats is dat de rol van de asymmetrische informatie. De kopers van de pakketjes die risicovolle beleggingen bevatten, hebben minder informatie over de inhoud van de pakketjes dan de verkopers. Hier geldt het theorema van de beperkte rationaliteit ( bounded rationality ) waarbij het voordeel van extra informatie voor de kopers niet opweegt tegen de kosten van die extra informatie. In dit geval gaat het echter om zulke grote bedragen, en om handelaars die zeer goed van alle ins en outs van de individuele transacties op de hoogte zijn, dat deze reden hier minder relevant lijkt. Vandaar dat de eigenlijke reden eerder gezocht moet worden bij de fallacy of composition, namelijk dat het systeem anders functioneert dan dat een analyse van de som van de onderdelen leert. Anders gezegd: een analyse die alleen betrekking heeft op het individuele niveau van banken, of op de merites van de verschillende derivaten om risico s in te pakken, is onvoldoende. De fallacy of composition De fallacy of composition in dit geval van risicospreiding houdt in dat wanneer alle individuele beleggers en financiële instellingen hun risico s in pakketjes samenvoegen met weinig risicovolle beleggingen en zo doorverkopen, op macro niveau het totale risico niet afneemt. Weliswaar zorgt de risicospreiding voor een lagere benodigde risicopremie vanwege een lagere te verwachten volatiliteit, de benodigde buffer om de schade van deconfiture op te vangen, blijft voor de totaliteit hetzelfde. Aangezien het financiële systeem wereldwijd een gesloten systeem is, komen de risico s die de banken en speculatieve beleggers in pakketjes hebben doorverkocht, uiteindelijk weer in vermomming op hun bordje (en binnen hun balans?) terug. Vanuit deze macro blik op het financiële systeem bezien we 4 mogelijke boosdoeners die de schokbestendigheid van het systeem hebben aangetast.